Foreign exchange market
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The foreign exchange market or currency market or Forex is the market where one currency is traded for another. It is one of the largest markets in the world.
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Market participants
Some of the participants in this market are simply seeking to exchange a foreign currency for their own, like multinational corporations which must pay wages and other expenses in different nations than they sell products in. However, a large part of the market is made up of currency traders, who speculate on movements in exchange rates, much like others would speculate on movements of stock prices. Currency traders try to take advantage of even small fluctuations in exchange rates. Sometimes they are able to profit from arbitrage.
According to the Bank for International Settlements' last triennal study (April 2004) (Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity 2004 - Final Results), transactions :
- were strictly interdealer (ie interbank) for 53 % ;
- for 33 % involved a dealer (ie a bank) and a fund manager or some other non-bank financial institution;
- and for only 14 % were between a dealer and a non-financial company.
Market liquidity
Foreign exchange markets are unique in the financial world in that exchange rates are highly sensitive to a great variety of factors, many different types of investors have access to the market, the market is very liquid, and currencies are traded around the clock. The main international banks continually provide the market with both bid (buy) and ask (sell) offers.
| Rank | Currency | ISO 4217 Code | Symbol |
| 1 | United States Dollar | USD | $ |
| 2 | Eurozone Euro | EUR | € |
| 3 | Japanese Yen | JPY | ¥ |
| 4 | British Pound Sterling | GBP | £ |
| 5 | Swiss Franc | CHF |
In the foreign exchange market there is little or no 'inside information'. Exchange rate fluctuations are usually caused by actual monetary flows as well as anticipations on global macroeconomic conditions. Significant news is released publicly so, at least in theory, everyone in the world receives the same news at the same time.
Currencies are traded against one another. Each pair of currencies thus constitutes an individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217 international three-letter code of the currency into which the price of one unit of XXX currency is expressed. For instance, EUR/USD is the price of the euro expressed in US dollars, as in 1 euro = 1.2045 dollar.
On the spot market, according to the BIS study, the most heavily traded products were :
- EUR/USD - 28 %
- USD/JPY - 17 %
- GBP/USD (also called cable) - 14 %
and the US currency was involved 89% of transactions, followed by the euro (37%), the yen (20%) and sterling (17%). Although trading in the euro has grown considerably since the currency's creation in January 1999, the foreign exchange market is thus still overwhelmingly dollar-centered. For instance, trading the euro versus a non-European currency ZZZ will usually involve two trades : EUR/USD and USD/ZZZ.
Around-the-clock market
Big foreign exchange trading centres are located in Hong Kong, Singapore, Paris and Frankfurt amongst others, while the biggest three are New York, Tokyo and London, of which London is the largest. The foreign exchange market is open 24 hours per day throughout the week (closing worldwide Friday afternoon at 5pm New York time, ie 2100 GMT, and reopening Sunday 1900 GMT when Wellington, New Zealand opens on their Monday morning). If the European Market is closed the Asian Market or US will be open on the other hand and so all world currencies can be continually in trade. Traders can react to news when it breaks, rather than waiting for the market to open, as is the case with most other markets.
Market Size
Average daily international foreign exchange trading volume was $1.9 trillion in April 2004 according to the above-mentioned BIS study :
- $600 billion spot
- $1,300 billion in derivatives, ie
- $200 billion in outright forwards
- $1,000 billion in forex swaps
- $100 billion in options.
For various reasons, exchange-traded derivatives never caught on the Forex market as they did on all other financial markets (although attempts to launch currency futures in the early 70s actually predate interest rate or stock index futures).
Mechanics of trading
The only real foreign exchange market is the 'deliverable' orders for individuals and businesses who need to buy and sell x currency at any rate.
It is possible for investors to speculate on currency fluctuations and realize profits by parking funds in one currency, and after it appreciates in value, switching to another. In our floating point system every investment in the world is calculated in some domestic currency. A Belgian dentist who makes 20% in U.S. dollar term on an investment in the DJIA, has to realize that if the U.S. dollar has gone down by 40% versus the Euro, then he has actually lost money in terms of his domestic currency, the Euro. Even if he invests in Euros he is not immune to currency movements, through the concept of purchasing power. Suppose he turns a Euro 10,000 investment in to Euro 11,000. Also suppose in this instance that the Euro is down versus the U.S. dollar by 20%. The price of imported goods will have increased, so it leads to inflation. In other words, even though our Belgian dentist has made a significant profit on his investment, his purchasing power has not increased as much, and might even have gone down
Like any market there is a bid/offer spread (difference between buying price and selling price). The real spread between currencies is actually 1 or 2 pips. In the EUR/USD price of 1.4238 a pip would be the '8' at the end. So the bid/ask quote of EUR/USD might be 1.4238/1.4239 - however a bank will mark up the difference to say 1.41 / 1.43. To most travelers exchanging 10 or 100 or even 1,000 dollars this is only a few dollars, but if you are a business exchanging millions, this can be a huge risk. To mitigate this risk a business will hedge a currency, for example buying a contract to buy 6 months worth of EUR at a set price. The company will never make money on the currency, but they will never lose, and the company can budget and determine prices accordingly.
Most individual currency speculators will trade using a broker which will typically have a spread marked up to say 3-20 pips (so in our example 1.4237/1.4239 or 1.423/1.425). The broker will give their clients often huge amounts of margin, thereby facilitating clients spending more money on the bid/ask spread. The brokers are not regulated by the U.S. Securities and Exchange Commission (since they do not sell securities), so they are not bound by the same margin limits as stock brokerages. They do not typically charge margin interest, however since currency trades must be settled in 2 days, they will "resettle" open positions (again collecting the bid/ask spread).
External links
- Foreign Exchange related material from the Federal Reserve
- Model Code from ACI - The Financial Markets Association, a Paris, France based industry association.
See also
| Financial markets |
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Economic subtypes:
Capital markets (Stock markets, Bond markets |
Primary markets, Secondary markets) |
Derivatives markets
(Futures Markets) Organisations: Stock exchange | Futures exchange Related Topics: List of stock exchanges | List of futures exchanges | Lloyd's of London | List of stock market indices |
